How To Think About Small To Mid Cap Biotech Firms: Profit-Taking On Arena

| About: Arena Pharmaceuticals, (ARNA)

After my first article, a commenter by the name of constable asked an interesting question about trading:

I was writing because I was struck by how many commentators on SA, including me, seemed at a loss after the Arena (NASDAQ:ARNA) success. I don't know what to expect now (I don't do binary small biotech caps much), I don't know what any patterns are, and I don't even know much *how* to think about it -- and that is where *I* need help. [Happily, so far with ARNA I've done roughly as you suggested, and I am content.]
I certainly would not listen to Kramer and his ilk (except perhaps as contrarians). I felt I learned more from the cacophony on SA ....
So, I appreciate your skepticism.

I was in a similar position a long time ago, and I'm no expert, but here are my two cents on the matter (using ARNA as an example):

Many people try to minimize worst-case loss or try to maximize best-case profit or some other strange combination. The best factor to focus on is regret. Books have been written on regret theory, but in general we define regret to be 'the difference between what I have now and what I could have had if I made the best decision'. Different textbooks have different definitions, usually involving 'payoff', but a quick wiki search reveals the essential definition.

This is not something restricted to trading. Amazon's Jeff Bezos discussed this in the context of his life. There are many ways to minimize regret, and it's a very long mathematical discussion (touching areas like stochastic calculus), but the essence is the same: for each possible outcome, look at your regret, and decide which plans action you are comfortable with.

ARNA is a particularly useful example. In 2010 it spiked to the 7 range on hopes of success with lorcaserin, and when they didn't pan out it quickly fell. In late April 2012 it started ramping on hopes of a nod from the FDA panel. I started taking positions in late April, with a cost basis of $2.40, for various reasons (which basically played out). It started ramping significantly as we neared the date, crossing 3.60 on the day before (that's a 50% profit).

At that point, the choices are to sit tight, take some profits, or dump the entire position. If the price fell such that I would end with a massive loss, I would regret not having sold everything. If the price skyrocketed (and based on the historical analysis, I expect it to hit 7), I would regret not having held onto shares. As you probably can imagine, the move that minimizes average regret is to sell some shares. There is no exact percentage rule, but what I like to do is sell enough shares so that the residual shares are pure profit. In my case, I sold 2/3 of my shares at 3.60 so that, even if Arena went bankrupt I would not lose principal. On the other side, if they got approval, I'd still have exposure.

They eventually got the nod from the FDA panel, so the price jumped. As there are a bunch of people who made a quick profit and would take their profits and go elsewhere, the price is expected to crater on the day after approval (this is part of a general pattern which I plan on discussing later). At that point, because the shares are pure profit, I didn't have to worry so much. I had the runway to wait until final approval.

So the stock price starts running again. What is the "range" to expect? Look back at the 5-year historical chart, and you will see that the trading range sat in the 10-20 range for more than a year, so that is probably the price range to expect if the drug is approved. Now, since the shares are pure profit, you are free to decide whatever you wish. Worst case scenario, even if you lose everything, your principal is protected. When the price crossed 12, I decided to dump 99% of my position. I knew that it could have run further, but I knew that I would regret having to close in 1-2 range far more than I would enjoy taking profits above 12. More importantly, there was absolutely no stress or concern going into the final approval date.

The key things to note regarding my approach is that I focused on regret and I made decisions based on my comfort level. You may be more or less aggressive and choose accordingly, but depending on your personality "taking profits early" may be better or worse than "missing out on future profits". You should take some time to understand yourself before doing regret analysis.

Now is definitely a good time to take some profits off the table if you haven't done so already, but there is room for upside, so my "recommendation" is to sell if you bought below 7, and hold otherwise.

Disclosure: I am long ARNA. Even though I am long, at this point those shares are pure profit.